Storms form when moisture, unstable air and updrafts interact. Similarly, a confluence of factors – volatility in public markets, tightened regulations,
maturing loans and uncertain foreign capital flows – is creating
a blast of volatility for U.S. commercial real estate (CRE) that we anticipate could lower overall private U.S. CRE prices by as much as 5% over the next 12
months. For nimble investment platforms, however, these swirling winds should create attractive opportunities over the secular horizon.

After the financial crisis, which sent prices sharply lower, commercial real estate in the U.S. has enjoyed growth with solid fundamentals. Rents have
steadily increased and demand generally continues to exceed supply. Improving fundamentals, though, have not been the primary driver of higher CRE prices.
Consider this: Since the fourth quarter of 2009, overall office prices have doubled (as have general CRE prices), yet national office rents have risen only
about 15% (see Figure 1). The primary price driver for U.S. CRE assets instead has been capital flows.

But capital flows have grown unstable over the past year due to fears over interest rate hikes and, more recently, events such as political and economic
uncertainty in China. While this instability began in the public CRE markets, it has blown in to private CRE as well, particularly in non-major markets.

CHANGING DIRECTIONS: REIT DEMAND HIT BY MARKET VOLATILITY

Real estate investment trusts (REITs) are generally registered with the SEC and publicly traded on a stock exchange. But they’re classified and often move
in tandem with financial stocks, which have been buffeted recently by global financial market volatility. Much to the dismay of REIT CEOs, daily returns of
REITs have had a 71% correlation to the broader S&P Index since the beginning of 2015. The result: Despite private CRE price indexes such as
Moody’s/RCA Index increasing over 7% since 2014, REIT prices have been essentially flat, and dropped as much as 10% on multiple occasions over the same
period (see Figure 2). As a result, REITs have generally traded below their net asset value (NAV) for the majority of the past 18 months. As capital
efficiency textbooks would dictate, this persistent discount to NAV has turned many REITs from net buyers to net sellers of U.S. CRE, suppressing a major
buyer within the market.

To put this into perspective, REITs acquired about $54 billion annually of private CRE from 2012 to 2014 (some 15% of total transaction volume), according
to Real Capital Analytics. However, in the second half of 2015 acquisitions plunged to $17 billion (less than 8% of total transaction volume) due to
heightened volatility.

In August of 2016, REITs will be reclassified as their own sector within the Global Industry Classification Standard, which could partly account for recent
outperformance. While a more specific benchmark should result in increased flows to REITs from index-conscious equity funds, REITs could still be exposed
to highly correlated and volatile global capital markets.

REGULATION – MORE CLOUDS AHEAD

CRE liquidity has declined in recent years, driven by post-financial crisis regulations such as Dodd-Frank and the Federal Reserve’s Comprehensive Capital
Analysis and Review (CCAR). This has intensified volatility for the sector during periods of broader public market sell-offs. In February, for instance,
oil-induced fears in the broader high yield debt markets led to redemptions that forced several hedge funds to unload positions, including subordinate U.S.
commercial mortgage-backed securities (CMBS).

Here again, the sell-off had little to do with actual CRE fundamentals. Instead, it highlighted an increasingly important headwind to U.S. CRE finance
broadly – reduced bank dealer inventories. As with other areas of fixed income, banks have traditionally served as market makers in CMBS. However, in
response to a variety of regulatory pressures, banks have reduced their balance sheet inventory by nearly half in the last two years (see Figure 3). The
impact of this inventory reduction is clear – hedge funds hold about 40% of subordinate U.S. CMBS positions, and as they began selling to meet redemptions
in February banks were unable to provide liquidity (or make a market). As a result, prices for these subordinate CMBS positions fell by as much as 20% in a matter of weeks.

CMBS loan origination platforms also have been crushed by the plunge in prices, as banks and originators found their recently originated loans, intended
for securitization, to be underwater based on CMBS pricing. According to Bank of America, CMBS issuance in the first quarter of 2016 tumbled by over 30%.

Not surprisingly, with CMBS representing over 20% of the debt origination market in 2015, the February fallout in CMBS had a notable impact on private CRE
as well. CMBS lenders increased rates on their debt quotes by 50–100 basis points and buyers reduced property bids to maintain target returns. Indeed,
broker transaction volume affirms this dynamic – first quarter transactions dropped 11% compared with the same period in 2015, according to CBRE Group.

Hardest hit were non-major markets, where CMBS represents over 35% of the non-multifamily debt origination volume. Many deals fell out of contract or
re-priced down by as much as 10% to 15%.

Regulation will remain a headwind for CMBS and CRE for the foreseeable future. Later this year, another reform – new risk retention rules – will be
implemented. These will require CMBS originators (or a long-term holder) to retain at least 5% of a new securitization. In essence, bank originators will
have to go from a “moving business” model to a costlier “storage business” model, which in turn means lower volumes and higher rates for CRE borrowers.

Finally, recent regulations are taking a toll on another significant sector of U.S. CRE – non-traded REITs. Enacted by the Financial Industry Regulatory
Authority with an implementation grace period that ended in April 2016, the rules require non-traded REITS to disclose asset-based valuations of their securities. This requirement has already revealed significant impairments to the NAV of many of these
platforms.

This has dramatically affected fundraising for U.S. non-traded REITs, which fell to $9 billion in the year ending January 2016, a 30% decline from the
2013–2015 average according to HFF. Furthermore, it’s likely the numbers will continue to trend down. Similar to CMBS lending, the negative impact will
likely fall disproportionately on non-major markets, as non-traded REITs were relatively more aggressive in these markets.

THE WALL OF MATURITY – ROLLING THUNDER

Interestingly, the confluence of these forces comes as the U.S. CRE market is set to experience a surge in forced liquidations. As is well known, more than
$200 billion of 10-year CMBS loans will mature over the next three years. Also, over the same period more than $50 billion of 10-year CRE debt and equity
funds will wind down. In many cases, these legacy funds have held on to sub-performing assets to retain fees; however, at the 10-12 year point, investors
typically have the right to force liquidation.

SWIRLING WINDS OF FOREIGN CAPITAL

Somewhat counterintuitively, the global public market volatility that has hurt REITs and CMBS has arguably had the opposite effect in the direct CRE
investment space. Here, the combination of negative interest rates in Europe and Japan, fears of currency devaluation in Latin America and Asia and a
continued thirst for “safe yield” has increasingly inspired long-term investments in U.S. CRE. As such, foreign private investment volume ballooned from
$22 billion in 2012
(8% of total volume) to $84 billion in 2015 (16% of total transaction volume), according to
Real Capital Analytics. Importantly, the impact has centered on major markets.

Prospectively, continued volatility could support additional foreign investment, as sovereign wealth funds remain underallocated to CRE, according to
Preqin. In fact, several sovereign wealth funds have recently announced significant increases in their planned CRE investments. For example, Norway’s
Government Pension Fund announced plans to increase its global real estate allocation by some $17 billion; the China Investment Corporation plans to double
exposure by about $35 billion.

To put this in perspective, these plans alone equated to over 10% of the total transaction volume in U.S. CRE in 2015. In addition, last December President
Obama signed the Protecting Americans From Tax Hikes (PATH) Act of 2015. The law reduces taxes on
U.S. CRE for many foreign pension funds and could prompt an additional $10 billion to $30 billion of cross-border investment into U.S. CRE, according to the National Association of Realtors.

That said, increasing dependence on foreign demand creates even more uncertainty for U.S. CRE, as capital flows are far from guaranteed: China has hinted
at increased controls on capital outflows; lower oil prices could curtail investment from the Middle East and Canada; and even certain U.S. presidential
outcomes could influence foreign investors’ confidence in U.S. CRE assets.

WEATHERING THE STORM: UNCERTAINTY AND VOLATILITY CREATE OPPORTUNITY

The pressure from volatility, regulations, maturing loans and uncertainty over foreign capital flows suggests prices could slump by as much as 5% over the
next 12 months,
with a disproportionate impact on secondary and tertiary markets.

However, this dynamic could create opportunities across U.S. CRE debt and equity markets, both public and private. In public CRE debt (CMBS), reduced
dealer inventories and the 10-year maturity wall will quickly alter underlying credit profiles in CMBS and could create attractive entry points for nimble
capital that understands CMBS structure and the underlying CRE assets. Similarly, on the public equities side, broad sell-offs like those in January and
February will likely create opportunities to invest in CRE at potentially cheaper levels than the underlying private assets, with potentially even better
liquidity. On the private side, regulatory pressures in CMBS should create financing gaps that could be filled by non-bank capital through subordinate debt
or preferred equity. Finally, sustained periods of public market volatility, as well as disproportionate foreign capital demand for core assets, could
create attractive arbitrage opportunities for larger platforms that can acquire mixed portfolios from forced sellers.

For flexible capital, this storm might be a welcome one indeed.

Summary

Pressure on U.S. commercial real estate from volatility, regulations, maturing loans and uncertain foreign capital flows suggests prices could slump by as much as 5% over the next 12 months.

This dynamic will create dislocations and financing gaps across U.S. commercial real estate debt and equity markets, both public and private, over the secular horizon.

For flexible capital, these dislocations could create attractive investment opportunities.

Disclosures

All investments
contain risk and may lose value. The value of real estate and portfolios that invest in real estate may fluctuate due to: losses from
casualty or condemnation, changes in local and general economic conditions, supply and demand, interest rates, property tax rates, regulatory limitations
on rents, zoning laws, and operating expenses. Mortgage- and asset-backed securities may be sensitive to changes in interest rates,
subject to early repayment risk, and while generally supported by a government, government-agency or private guarantor, there is no assurance that the
guarantor will meet its obligations. REITs are subject to risk, such as poor performance by the manager, adverse changes to tax laws or
failure to qualify for tax-free pass-through of income. There is no guarantee that these investment strategies will work under all market conditions or are
suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market.
Investors should consult their investment professional prior to making an investment decision.